In the over thousand pages that make up the Conference Report on on the Tax Cuts and Jobs Act, the most intriguing bit is on page 24 - "20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year." The provision has caused quite a stir in agricultural circles.

That makes for a three-part story. And I can't tell it fairly without getting a little technical, but even if that turns you off, be patient. We'll start with the farmers who were the intended beneficiaries, but just a bit of technical background first.

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Subchapter T

Some parts of the Internal Revenue Code have worked themselves into common language like 401(k) and 501(c)(3). One of those is Subchapter S, which allows a corporation to make an "S election" and become an "S corporation". S corporations are generally not subject to corporate income tax. Income or loss is divided among the shareholders and reported on their returns. Distributions are generally not taxable.

A corporation becomes an S corporation by filing an election. Qualification for the election is based on who the shareholders are and how many of them there are. There are a variety of entertaining ways in which you can get kicked out of S corporation status, but it is generally a pretty cut and dried issue as to whether you are one or not. S corporations file Form 1120-S

Subchapter T might be viewed as another way to get to the same bottom line. Corporations that fall under Section 1381 can deduct some (could be most or all) of their dividends. The owners then generally report those patronage dividends as ordinary income, sometimes, maybe usually, business income.

Putting aside some complications and exceptions a corporation qualifies for this treatment if it is "operating on a cooperative basis". There is no election involved in being considered a cooperative or to be more precise "a corporation operating on a cooperative basis". (We'll just use cooperative from here on in. Just remember we are using the tax definition.) Corporations "operating on a cooperative basis" file Form 1120-C

Here is why you probably have heard of Subchapter S, but not Subchapter T. In 2015 according to IRS Publication 6292, there were 6,893,412 corporate income tax returns (1120) of all types filed. Of those, 4,717,161 were 1120-S. Form 1120-C - not so many, only 9,763.

The other thing is that whether a corporation is a cooperative is not as cut and dried. There are no regulations, sparse rulings and little case law.

Section 199

The brand new Section 199A can be viewed as a souped up version of old Section 199 which is repealed. Like 199A, Section 199 (Income attributable to domestic production activities) was essentially a deduction based on the net profits from certain business activities. The deduction was only 9% and in all cases was limited by 50% of the W-2 deductions related to the activity.

There was a special rule in Section 199 for agricultural cooperatives. Section 199(d)(3) allowed the deduction to be computed at the cooperative level and passed to the patrons. Without that provision farmers, some of whom do not pay much W-2 income, would not have gotten credit for the W-2 income paid by the cooperatives, which is sometimes substantial. That brings us to the farmers and Section 199A.

The Farmers In The Dell

Teresea Castanias is a CPA and now a sole practitioner who incidentally lives on a farm. One of the things she does in her practice is cooperative tax consulting. She is retired from a long career at KPMG, which included, in effect, helping to write the tax law for cooperatives.

For example, in 2005, I led a coalition of cooperatives to lobby Congress for special rules for cooperatives in the Section 199 Manufacturing Deduction by providing Congressional staff with specific items to ensure that the provisions worked for cooperatives, including the attribution rule and add-back of patronage payments. Without this effort, Section 199 would not have worked for agricultural cooperatives. This provision has been extremely beneficial to all agricultural cooperatives.

She is still in touch with the players in the industry. As even a political naif like myself was able to discern, any Republican senator willing to hold his breath before agreeing to vote for TCJA would get a puppy or some candy or a case of beer. That eighteen word clause - "20 percent of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year" was Senator John Hoeven's puppy. The intent according to Ms. Castanias was to give cooperatives and their patrons the same sort of treatment under Section 199A as they had under Section 199.

UNITED STATES - APRIL 4: Sen. John Hoeven, R-N. Dak., participates in the Senate Energy and Natural Resources Committee hearing on efforts to protect U.S. energy delivery systems from cybersecurity threats on Tuesday, April 4, 2017. (Photo By Bill Clark/CQ Roll Call)

As things went though, the provision had been in neither the House nor the Senate bill and it was kind of air dropped into the committee bill without a lot of understanding of how it fit in with everything else. The effect was kind of startling. Farmers selling their produce through cooperatives would no longer be getting a 9% deduction of a net profit - subject to a W-2 requirement.

Instead they get a deduction that is 20% of their gross, which could, in effect, make farming tax free. The implications were seen pretty quickly much to the chagrin of companies that were not cooperatives that farmers also sell to. This article - Tax Trouble by Amy Bickel and Larry Drelling explains the drama.

There is talk of there being a fix including a statement from USDA Under Secretary Greg Ibach,

The aim of the Tax Cuts and Jobs Act was to spur economic growth across the entire American economy, including in the agricultural sector. While the goal was to preserve benefits in Section 199A for cooperatives and their patrons, the unintended consequences of the current language disadvantage the independent operators in the same industry. The federal tax code should not pick winners and losers in the marketplace. We applaud Congress for acknowledging and moving to correct the disparity, and our expectation is that a solution is forthcoming. USDA stands ready to assist in any way necessary.

The intriguing question to me is whether the fix, if there is one, will affect the unintended beneficiaries of Senator Hoeven looking out for the farmers.

Worker Cooperatives

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The farmers are getting their patronage dividends by selling their harvest through producer cooperatives. Less well known, but becoming more of a thing in some areas are worker cooperatives. Here we are talking about something of a movement and a philosophy (which probably has something to do with the agricultural cooperatives in their early days). The United States Federation of Worker Cooperatives describes it this way.

Worker cooperatives are business entities that are owned and controlled by their members, the people who work in them. All cooperatives operate in accordance with the Cooperative Principles and Values. The two central characteristics of worker cooperatives are: (1) worker-members invest in and own the business together, and it distributes surplus to them and (2) decision-making is democratic, adhering to the general principle of one member-one vote.

USFWC identifies over 300 "worker cooperatives and democratic workplaces" in the United States. They cover quite a variety of fields and some of them have been around for quite a while. The San Francisco Mime Troupe goes back to 1959. I didn't call them up, because I figured they wouldn't have much to say. And the Berkeley Massage and Self-Healing Center was founded in 1969. There is a distinction we need to make here. Section 1381 is not the only tax form that will let you embrace the cooperative principles. USFWC defined cooperatives might choose to organize as LLCs and be taxed as partnerships or run as S corporations.

Further there are quite a few democratically run worker owned businesses that don't really think of themselves as part of any sort of movement. The boutique accounting firm that is still my day job probably falls in that category.

Regardless, quite a few worker owned cooperatives are taxed as cooperatives under Section 1381. As far as I can tell, they will tend to pay reasonable salaries or wages and then pay out patronage dividends that generally represent a small bonus. There is a running dispute about whether the patronage dividends are subject to self-employment tax, which I describe elsewhere.

Teresa Castanias has advised a few worker owned cooperatives that have decided to go the Section 1381 route. She has the slightly jaundiced attitude that thirty plus years in public accounting will give you when it comes to the idealistic piece of the enterprise commenting that you can have all the kumbaya you want, but in the end you still have to make money.

I talked to my roofer friend Mike Kileen (We are part of the same family, but related in a way that is too complicated to describe here.) There are quite a few worker cooperatives in the construction trades in the Amherst area. He doesn't see them doing that great and told me he thought it would be a great idea, if it were not for human nature.

Personally, I would suspend judgement until I have done more study, but am open to the idea that the problem might be the business culture of the United States rather than human nature.

Regardless, Ms Castanias agrees that as written the statute will give a small tax benefit to the workers in cooperatives that go the 1381 route. And that seems unlikely to have been on the mind of the Republicans who dropped the provision into the act. Consider the definition of "operating on a cooperative basis" (Section 1381) in the case law (Puget Sound Plywood a 1965 Tax Court decision):

(1) Subordination of capital, both as regards control over the cooperative undertaking, and as regards the ownership of the pecuniary benefits arising therefrom ; (2) democratic control by the worker-members themselves; and (3) the vesting in and the allocation among the worker-members of all fruits and increases arising from their cooperative endeavor

And that brings me to my wicked scheme. Here we have a provision that was meant to help farmers, but probably helps them more than it should. Incidentally it helps people in a variety of trades - bicycle mechanics, house cleaners, construction workers, bakers - who have chosen a particular way to organize themselves.

It gives them a little piece of the deduction they would get by being gig workers, since there are not many worker cooperatives with people earning 150k plus. But what about "fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage service"?

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Some of them make really good money and will have taxable income well over the $415,000 (joint return), where the 199A deduction will be totally phased out regardless of how much there might be in W-2 wages. Why don't they start worker owned cooperatives? The patronage dividends, in the statute as written, do not have any sort of restriction including ruling out the disfavored fields.

Can professionals organize as worker owned cooperatives? My friend tax attorney Howard Medwed is very skeptical and thinks that it would not work in the absence of a state cooperative statute. When I explained the whole situation with how the odd provision came about he suggested that I attach a sausage recipe to the post, referring to a quotation often apparently misattributed to Bismarck. (My personal sausage recipe is to go to Town Pizza in Auburn and order a sausage grinder.)

Teresa Castanias. on the other hand, is more sanguine about the notion. She told me that there actually was an auditing firm in Illinois that organized as a worker own cooperative. She said they were acquired by Clifton Larson Allen a few years ago. She thinks the idea probably works as the law is currently written.

The Practical Problems

For an existing professional corporation that is a C corporation, I see executing the cooperative strategy to be pretty low risk. It would just be a matter of changing the bylaws to "operate cooperatively". A typical professional practice would probably not end up being viewed as meeting all the eligibility requirements for membership in the United States Federation of Worker Cooperatives, but that's not the tax law.

Unfortunately professional practices organized as C corporations have fallen out of favor, for good reason, as a close reader of this blog would know. So that limits the number of practices for which the 1381 strategy would be low risk and easy peasy. The idea of converting a partnership to a C corporation or revoking an S election and risking double taxation on a practice sale for a benefit that may prove fleeting is not one that I would recommend. But, but, but..

This is where I go a little crazy. Teresa Castanias seems sure this idea doesn't work. Here goes anyway. I have not found anything that prevents an S corporation from changing its bylaws to "operate cooperatively" pay some deductible patronage dividends and have the balance flow through based on shareholding. I can think of many reasons why that should not work, but I can't find any authority at all. If that is the case, it would be a game changer. I would often be told in partner's meetings that I had just enunciated the "stupidest --------- idea ever". This one may well top all of them. I'll let you know.

The Fix May Be In

I ran the idea by one of my CPA friends who is closer than I to the amber waves of grain.

I will ponder it, but I think it is an impossible circle to square.

Cooperatives have to be run “on a cooperative basis.” This means patron ownership, and it means (probably) that it would be impossible to police one class of stock and eligible ownership. While “cooperative basis” isn’t precisely defined, I don’t think the co-op scheme – which is a form of pass-through to begin with – is compatible with Subchapter S.

I have to think the co-op thing will be shut down, as it will otherwise transform the ag economy, and then other sectors if it isn’t, while making farming a tax-free game. I could be wrong, as I understand the newly tax-free farm sector isn’t crazy about it. Still, Grassley says it has to be fixed and will be, and if he thinks it’s too much, it probably will change.

So, what’s the status? It is important to note that tax staff members of the Senate Finance Committee, in consultation with the House Ways and Means Committee, already have begun drafting legislative language to enact a solution. The Joint House-Senate Committee on Taxation also will be engaged in an effort to ensure that a legislative solution to this complex issue is done correctly this time around. Importantly, NGFA has been asked by these key congressional tax-writing committees to continue to stay fully engaged and to serve as a sounding board to vet key policy questions – again, a recognition of our balanced membership composition and a responsibility that NGFA willingly accepts on behalf of its member companies’ interests.

Unfortunately, if the language they use borrows heavily from old Section 199, there will be nothing for them. Maybe the United States Federation Worker Cooperatives should be looking for a seat at the table. I don't know about you, but I am rooting for the house cleaners.

I have been a CPA for over 30 years focusing on taxation. I have extensive experience with partnerships, real estate and high net worth individuals.
My ideology can be summarized at least metaphorically by this quote:
"I have a total irreverence for anything connect...